How saving works: Your essential guide to building up a nest egg

A rainy day fund can give you protection against unexpected bills or losing your job.

It can also be the means to do something you could never manage to pay for from your monthly income, such as splash out on a big purchase.

Tapping into your savings is also the key to many of life’s major events, such as buying a car, getting married or buying a home.

Building up a savings pot is also the route to financial independence. It’s a lofty ambition, but if you save enough money then you may never have to rely on anyone else for your income again.

Whichever of the reasons above you choose for setting money aside, or the multitude of others out there, a saving habit is a good one to get into.

The good news is that once you decide to get that saving habit there are ways to make it work even better.

Nest egg: Saving makes sense for many reasons and is a great habit to get into

Building a savings pot

The traditional place to save is into a bank or building society account. The benefit of doing this is that the bank or building society will pay you for depositing money with them in the form of interest.

Building up a savings pot therefore involves two elements: the money you save, plus the interest you get.

The amount you put in will generally make up the bulk of your savings, as it can take a very long time for the interest you earn to outstrip this.

That said, the power of interest built up over time can be substantial, which can give your savings a healthy boost.

WHY DO BANKS WANT YOUR MONEY?

Banks pay interest because they want your money to help balance their books.

Despite what many economics textbooks will tell you, banks do not take savers deposits and then lend them out. Instead, as the Bank of England has explained, banks actually create new money when they make loans.

However, the more money banks can take in from savers, the easier it is for them to balance their books and the stronger their finances are the more they can ultimately lend out and make a profit on the gap between the cost of getting money in and the interest they earn from lending it out.

Share this article

HOW THIS IS MONEY CAN HELP

When it comes to saving there are two friends you need to know about: regular saving and time.

Regular saving is a great way to steadily build up your funds. It is far easier to save £50 a month for a year, than to save £600 in one go.

Getting money out of your account and into a savings pot every time you get paid, is a savings trick that pays off.

If you get the money straight out, you are both less likely to notice it making a dent in your disposable income and less likely to spend it before you can save it.

On top of that, the way regularly saved money builds up over time can be very satisfying. Do this over a long period of time and you might be surprised at the end.

Great minds: The modern world's most famous scientist Albert Einstein was a fan of compound interest - his 'eighth wonder of the world'

Save £100 a month for two years and you will have £2,400 – a substantial sum to see in your account – and that’s before any interest.

The other great saver’s friend is time – and this is thanks to the magic of compounding interest.

Compounding involves earning interest on the interest you have already been paid. It allows your savings pot to grow like a snowball rolling down a hill, picking up extra little bits as it trundles along.

Stick £100 under your bed for 10 years and you will still have £100 at the end of that period.

Stick it in a savings account with a 3 per cent interest rate and you will have £135.

If you can find a savings account that pays 5 per cent you would have £165 at the end of that ten years.

The modern world's most famous scientist and thinker Albert Einstein was a fan of compounding.

He offered this view: 'Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.'

An example of how this can work is to consider what putting £10,000 into a savings account that promised to pay you 5 per cent forever would deliver.

After 10 years you would have £16,500

After 20 years you would have £27,100

After 30 years you would have £44,700

After 40 years you would have £73,500

What really pays off though is combining regular saving with compound interest.

Pay £100 a month into that savings account that promises to pay 5 per cent forever and after 20 years you would have put in £24,000 but have a pot worth £41,100.

In fact, it is with regular saving that an extra ten years of compounding can really pay off.

Saving £100 a month into that account for 30 years would more than double the pot to £83,200.

Low savings rates

The problem savers face right now is the low interest rates on offer. Whereas in the past 5 per cent savings rates were common, now you would struggle to get anywhere near that.

We have used the 5 per cent rate example above to show how compounding works.

In reality, the best rate you could hope for now is about 3 per cent on a five-year fixed rate savings account, or about 1.5 per cent on an instant access account.

These poor returns have been triggered by low central bank interest rates - the Bank of England base rate has been at 0.5 per cent for six years - and by the support for banks and building societies in the form of cheap money to lend out under the Funding for Lending scheme. To learn more about this read our When will interest rates rise? round-up.

The effect of low rates on savings growth is substantial.

Pay that £100 into a savings account that promised 2 per cent forever and after 20 years you would have £29,500 and after 40 years you would have £49,300

Rainy day fund: Having some money stashed away to tide you over is a wise move

Instant access or fixed rate: When do you want your money?

There are lots of different types of savings account but they broadly fall into two camps – ones you can get money out of at short notice and ones where your money is tied up for a set term.

In general, the longer you are willing to tie your money up for, the higher the interest rate you will be paid.

A higher rate is tempting but you need to be careful not to tie up money you may need quick access to. Some accounts won’t let you get at the money early under any circumstances, but others will make you pay a hefty penalty.

A middle ground is accounts with special clauses. Perhaps you may need to give 60 days notice, or can only pay in a limited amount each month, or must pay in a set amount each month over a certain period. Again, in return for the limits imposed, these will pay you a higher rate.

Why saving in a cash Isa makes sense

Unfortunately, there is something lurking out there that eats into savers’ returns – its name is tax.

In theory, savers must pay tax on their interest at the same rate they pay on their earnings.

That turns a 3 per cent savings account rate into a 2.4 per cent one for a basic rate taxpayer and a 1.8 per cent one for a higher rate taxpayer.

Fortunately, there is a perfectly legal tax dodge that can beat this - the cash Isa.

If you save into a cash Isa savings account you do not pay tax on your interest. You can save up to £15,000 a year into a cash Isa and all the interest you earn from it is tax-free. With cash Isa and standard saving account rates broadly level, it therefore makes sense to save into an Isa.

In addition to this from April 2016 the first £1,000 of savings interest is tax-free for basic rate taxpayers, while those paying higher rate tax get their first £500 tax-free.

At current savings rates, you would need a very big pot to earn £1,000 of interest.

In an instant access account with rates at 1.5 per cent you would need £66,700 and in a five-year fixed rate account with a rate of 3 per cent you would need £33,300.

These sums may sound like an unattainable target and make you think it’s not worth bothering with an Isa. There are three important things to remember though:

Firstly, a new government could change this but is much less likely to scrap the cash Isa system

Secondly, over your saving lifetime you may build up such a big pot, so keeping it safe from tax makes sense.

Thirdly, interest rates are at record lows and one day they will rise. When that happens the pot you need to get £1,000 of savings interest will shrink – at a 5 per cent savings rate it is £20,000.

That’s why it still pays to save into an Isa.

THIS IS HOW MONEY WORKS

This is How Money Works is our section that explains the basics of what people need to know about their finances and how to make more of them.

We believe financial education is important, whatever your age, and aim to build up a library of guides, tips and answers to common money questions.

Do you want to automatically post your MailOnline comments to your Facebook Timeline?

Your comment will be posted to MailOnline as usual

We will automatically post your comment and a link to the news story to your Facebook timeline at the same time it is posted on MailOnline. To do this we will link your MailOnline account with your Facebook account. We’ll ask you to confirm this for your first post to Facebook.

You can choose on each post whether you would like it to be posted to Facebook. Your details from Facebook will be used to provide you with tailored content, marketing and ads in line with our Privacy Policy.